New Tax Rankles Medical Device Makers

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Jim Corbett, the CEO of
Vertos Medical Inc., says a noninvasive procedure invented by his company is a breakthrough in the treatment of lumbar spinal stenosis, a common affliction of the elderly that makes it painful to walk or stand.

Corbett wants to make the technology – known by the brand name “mild” – more widely available. But he fears that a new 2.3 percent federal excise tax on U.S. sales of medical devices, levied since Jan. 1 under the Affordable Care Act, will dampen investor ardor and drain resources that could be used for development, marketing and physician training.

Corbett also frets that the tax will lengthen Vertos' path to profitability, especially since the device is the Aliso Viejo company's only source of revenue.

Thousands of other medical gadgets and supplies, produced by device makers across the nation, are subject to the same tax. In Orange County, a hotbed of medical device manufacturing with more than 250 firms and tens of thousands of employees active in the industry, the tax is not sitting well. Some of those companies, like Vertos, are still in the startup stage and not yet profitable. They are likely to be the hardest hit.

The medical device tax is one of many measures in the Affordable Care Act intended to pay for the roughly $1.3 trillion that will be needed to provide health coverage over the next 10 years to an estimated 27 million Americans who are currently uninsured. The tax is expected to fill about $29 billion of that gap.

Proponents of the device tax say that medical companies should be willing to help offset the cost of expanding health coverage because they stand to profit handsomely from all the new potential customers.

But industry advocates say they do not believe that millions more insured Americans will necessarily translate to higher revenues. They contend the tax is a threat to the kind of innovation that actually serves the central purpose of the new health care law – affordable care.

Corbett says his company's “mild” technique is safer, quicker and significantly less expensive than the standard alternative of open surgery. It is a short outpatient procedure requiring no anesthesia and costs less than $5,000. Open surgery, which means a few nights in the hospital and a nonnegligible risk of side effects, can cost up to five times more.

“So here is this procedure, which could save the system hundreds of millions of dollars, but they tax me and slow me down to do it,” he said.

“It just means we are further away from profitability. It's an unnecessary evil,” says the company's CEO, Tom Frinzi.

New demand

Industry executives dispute the assumption of device tax proponents that the financial burden on medical manufacturers will be offset by a sharp rise in demand for their products.

Gary Karr, spokesman for the Washington, D.C.-based Advanced Medical Technology Association, the industry's main lobbying group, argues that medical equipment is disproportionately used on elderly patients, who already are covered under Medicare. The newly insured are “likely to be healthier and younger – not people who are users of medical devices,” he says.

Karr's logic holds true for companies like Vertos and WaveTec, since lumbar spinal stenosis and cataracts are preponderantly conditions of older patients – people like Angelo Lunetta, 81, who was in tremendous pain and had to use a walker because of stenosis. After he underwent the “mild” procedure a little over two years ago, the pain largely disappeared.

“I wasn't bent over. I was standing up straight, and I don't use a walker anymore,” Lunetta said.

But manufacturers produce thousands of medical devices for all types of illnesses, not all of them geared to older patients. “It's not like people under 65 don't use any medical devices at all,” said Paul N. Van de Water, an analyst at the Center on Budget and Policy Priorities, in Washington, D.C. “People under 65 unfortunately still have heart attacks and get other conditions and are subject to scans and tests and what not.”

Van de Water argues that even a 1 percent increase in demand for devices would offset almost half the tax, “and the increased demand could be more than 1 percent.”

The effective tax also will be less than the nominal 2.3 percent rate in many cases, because medical device makers that sell directly to hospitals and medical offices rather than through wholesale distributors are taxed on only 75 percent of the sales price, according to the U.S. Treasury.

But that is scant comfort to owners of medical device companies.

What rankles them most is that the tax is imposed on their revenues rather than their profits. “I am paying a tax and I don't make any profit. That's crazy,” says Corbett, the Vertos chief.

Industry advocates say the top-line tax could translate to an extra 10 percent to 20 percent off the bottom line. The impact on larger and more diversified companies, however, is likely to be smaller than that.

Impact on innovation

Edwards Lifesciences, the Irvine heart valve maker, sells 57.2 percent of its equipment outside the United States, where the excise tax does not apply. The company expects the tax to cost it around $20 million – or 6.8 percent of its 2012 net income. That is still a hit to earnings per share and will surely not please investors. But it is a manageable
headwind for a company with nearly $2 billion in annual sales.

It's a different story for owners of smaller companies, who argue that the tax puts a particular onus on them because they often are not profitable and need every dollar they can get to reach critical mass. Unlike the bigger companies, they often have only one product line and sell it largely or exclusively inside the U.S., leaving them highly exposed to the new tax.

Vertos sells 100 percent of its “mild” technology in the U.S., for example, while about 95 percent of WaveTec's ORA System sales are domestic.

“This device tax disproportionately impacts the small companies with the narrowest margins and the greatest likelihood of creating innovations,” says U.S. Rep. Ed Royce, R-Fullerton, one of nearly 200 House co-sponsors of a bill to repeal the tax.

The House passed the repeal bill in June, but the Senate never took it up. The measure was reintroduced last month in both houses with significant bipartisan support, but its fate likely will depend on the highly uncertain prospect of Republicans and Democrats agreeing to new revenue measures to replace the device tax.

Some companies say they will have to cut back on research and development, freeze hiring plans or raise prices – and maybe all three – to absorb the impact of the tax.

“As we're growing our business, we naturally would add more people,” says WaveTec's Frinzi. “But we're not going to do that this year until we see what the impact of this tax will be.”

Dan Tran, an Orange County ophthalmologist who has performed more than 3,000 cataract surgeries using WaveTec's ORA System, says it would be a shame if companies were constrained in their ability to bring such medically valuable innovations to fruition.

He says he is more worried about the future of innovation than by the risk of having to pay a higher price because of the tax.

“They are taking the ability to do the surgery and the accuracy of the surgery to the next level, and that's awesome,” Tran says. “I hope that these technologies will continue to flourish and to improve in order to allow us to deliver better care and better outcomes to patients.”

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